Wednesday, February 11, 2009

I think I like this plan

CalculatedRisk describes his view/guess as to the administration's plan.  I hope he's right, because it sounds very reasonable.  Excerpt:
It sounds like the stress tests could be completed within "weeks" at some banks, and I think 30 days is sufficient for all 18 or so banks with $100 billion in assets.

The banks will probably fall into one of three categories:

1) No additional assistance required. These banks will definitely want this publicized!

2) The banks in between that will need additional capital. This is where the Capital Assistance Program comes in:
Capital Assistance Program: While banks will be encouraged to access private markets to raise any additional capital needed to establish this buffer, a financial institution that has undergone a comprehensive “stress test” will have access to a Treasury provided “capital buffer” to help absorb losses and serve as a bridge to receiving increased private capital. ... Firms will receive a preferred security investment from Treasury in convertible securities that they can convert into common equity if needed to preserve lending in a worse-than-expected economic environment. This convertible preferred security will carry a dividend to be specified later and a conversion price set at a modest discount from the prevailing level of the institution’s stock price as of February 9, 2009.
emphasis added
3) Banks that will need to be nationalized or sold.

There are still several issues:
1.  How do you announce the results?  Uncertainty is bad and announcing the results piecemeal will cause great uncertainty.  I think it might be better to announce a fixed date upon which the results for all large banks will be announced.  Even then, I can't even imagine the options market behavior leading up to that date.

2.  Getting new money injected can be tricky.  Especially difficult is figuring out what the government should get in return.  I think that aiming for public-private partnerships would work well.  For example, tell firms that need money, "Listen, if you want money, we'd prefer you arrange for private transactions, such as those executed between Berkshire Hathaway and Goldman Sachs, General Electric, and Harley Davidson.  For every dollar you raise privately, the government will be willing to provide up to $10 in exactly the same structure deal."  This works for both liquidity issues and solvency issues.  If a bank isn't able to convince private investors (including the managers) to raise 10% of the needed cash, I think it's hard to make a case that the government should be willing to save it.

3.  How do you nationalize?  I assume this isn't simply a purchase of 100% of the firm's equity at the most recent market price.  Is it just the OTS coming in like they normally do?  Am I overthinking this?

4.  What's happening to the lenders?  We can't have equity holders wiped out while debt holders are made completely whole.  And what about pension obligations?  I don't know what the solution to this is.  I suspect Luigi Zingales would argue for a cram-down, and I largely agree with him.  But I'm not sure I'm considering all the important factors.  For example, what happens if we piss off foreign debt holders?  Is that important?

In any event, these are difficult challenges.  I think, though, that things are moving in much better directions than they were in October of last year.  In terms of the stock market, it seems clear that investors do not like uncertainty, but I'm convinced that the long-term outlook of the U.S. economy is better now than it was in October.   

That means either investors were still too confident in October or investors are too pessimistic now.

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